Edited by D. G. Smith and Andrew S. Gold

Hossein Nabilou and Alessio M. Pacces

This chapter deals with the economic rationale for regulating shadow banking. It discusses whether the regulatory initiatives proposed by academics and policymakers are consistent with this rationale. We posit that the ultimate goal of financial regulation is to promote financial stability. Therefore, we evaluate shadow banking regulation based on its ability to reduce financial instability efficiently. Regulating shadow banking is challenging because shadow banking is often defined by reference to what it is not, namely, licensed or official banking. However, such an approach does not capture the essence of the shadow banking problem. The official banking system has implicitly or explicitly supported a significant part of what is known today as shadow banking. For instance, the asset backed commercial paper (ABCP) conduits or the structured investment vehicles (SIV), which were exposed to the United States (US) housing market during the global financial crisis (GFC), all enjoyed guarantees by banks – so-called ‘put options’ – by way of contract or reputation. The remainder of shadow banking was still problematic for financial stability because of the contracts in which shadow banks were counterparty to banks. American International Group (AIG), for instance, was counterparty to a significant part of the banking system relying on credit default swaps (CDS) to insure against the default of mortgage-backed securities (MBS).

Iris H.-Y. Chiu and Iain G. MacNeil

‘Shadow banking’ refers to a range of activities that have bank-like character, that is, credit intermediation, liquidity and maturity transformation, and that are undertaken outside the regulated banking system. This can mean activities carried out by non-bank entities that mimic bank-like activities, but can also refer to activities carried out by banks and other regulated firms that do not always operate within the established fabric of regulation they are subject to. Although such activities may be seen as a form of financial innovation, the relationship between innovation and regulatory arbitrage remains uneasy. The former is often viewed more positively than the latter, although it is clear from history that the former has often driven the latter (for example, the emergence of the Eurobond market). The Financial Stability Board (FSB) has provided leadership in developing international surveys of shadow banking activity around the world and policy thinking to govern these areas. In 2013, the FSB set out in a policy document the need to consider how shadow banking activity affects financial stability, but its focus was inevitably on known areas whose risks have played out in the global financial crisis of 2007–09. The spotlight on these areas has nevertheless led to regulatory reforms in many parts of the world, discussions of which are canvassed in this volume, but issues remain outstanding in relation to the effectiveness and scope of reforms.

Tom R. Tyler

This chapter reviews the effectiveness of deterrence, in and of itself as well as relative to the influence of consensual models of regulation that rely upon legitimacy to motivate compliance. The law governing corporate criminal enforcement, and the law and economics scholarship designed to inform it, treats deterrence as the primary goal and coercion through threatened sanctions as the most effective tool to achieve this goal. Yet the available evidence on the causes of misconduct suggests that although people do respond to threatened sanctions, the influence of coercion is often overstated relative to its actual influence upon law-related behavior. In addition consensual approaches have been found to be more effective than is commonly supposed. Taken together these findings suggest the desirability of developing a broader approach to corporate regulation using both coercive and consensual models of regulation. Given the strength of the findings for consensual models, the persistence of coercive models as the dominant and even exclusive approach to corporate crime is striking. That dominance suggests the importance of focusing on the psychological attractions of coercion to people in positions of authority. It is suggested that those in authority are attracted to this approach not only because of evidence that it can be effective but also due to the psychological benefits it affords them.